As discussed in more detail in a prior issue of MoFo Tax Talk,1 the HIRE Act treats as a U.S.-source dividend any “dividend equivalent” for purposes of U.S. withholding tax provisions. A “dividend equivalent” is (i) any substitute dividend (made pursuant to a securities-lending or “repo” transaction), (ii) any amount paid pursuant to a “specified notional principal contract,” and that is contingent on, or determined by reference to, the payment of a U.S.-source dividend, and (iii) any amount that the Treasury determines is substantially similar to a payment described in (i) and (ii). A specified notional principal contract may include equity swaps and as a result a dividend equivalent may include payments under an equity swap that are determined by reference to a dividend distribution on a U.S. equity security.
To address these HIRE Act consequences, the International Swaps and Derivatives Association (“ISDA”) released a protocol (the “Protocol”) amending its standard equity swaps documentation. The Protocol includes the following changes: (1) the party to an equity swap that is required to withhold U.S. tax on a dividend equivalent will not be required to pay a gross-up; (2) the addition of representations by the payee under an equity swap (e.g., representations such that the equity swap should not be considered a specified notional contract and representations that the payee will meet the requirements to avoid the new 30% FATCA withholding tax); and (3) the addition of certain termination rights (e.g., in the event there is a substantial likelihood the U.S. payor would otherwise be required to pay a grossup on the next scheduled payment date, or the IRS provides written notice of an intention to assess tax in connection with an equity swap). Our understanding is that certain foreign counterparties are resisting these provisions and that including or not including them is the subject of case-bycase negotiation. More information on the Protocol including a list of adhering parties can be found at: http://www.isda.org/isda2010hireactprot/hireactprot.html.